How to Overcome the Challenges of Bond ETF Investing

One of the fundamental criticisms of fixed income ETFs is that many indices are constructed according to market cap. The larger a company is, the more debt it is likely to have

Sam Shaw 18 November, 2015 | 11:20AM
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The appetite for passive investing shows no signs of waning. Today’s two hottest sectors? Smart beta and fixed income.

Money is moving into fixed income ETFs at a rapid pace as many active fund managers are finding it increasingly difficult to beat their benchmarks, especially in some of the more ‘vanilla’ aspects of the market, such as UK gilts.

“That has provided a nice tailwind for the ETF space,” said Antoine Lesné, head of ETF sales strategy, EMEA at State Street Global Advisors.

Just five years ago, worldwide fixed income ETFs accounted for $192.5 billion of assets under management. At the end of last month that amount had grown to $487 billion, with the pace of growth accelerating.

That said, the sector is still dwarfed by active management, with more than $5 trillion held in fixed income actively managed funds.

While equity ETFs have been around since the late 1980s, most bond products have launched since the global financial crisis, with growing traction supporting their investment case.

They are also vastly more complex.

Peter Sleep, senior portfolio manager at Seven Investment Management, made the simple point: “Take something like IBM. It has one stock, but 90 different bonds.”

With such a constant rate of flux in the underlying markets, with numerous trading channels it presents a challenge to the ETFs and their benchmarks, which are fairly precise.

Sleep said: “They will have their iBoxx or Barclays benchmark but might only hold 200 or so of the underlying securities, which is fine when they want to buy but makes it more difficult when they come to sell.”

As a result, innovation in this space is rife.

ETF Providers Innovate to Boost Returns

One of the fundamental criticisms of fixed income ETFs is that many of its indices are constructed according to market capitalisation. The larger a company is, the more debt it is likely to have. Therefore the more significant components of the index you are tracking are the most heavily indebted companies – seeming somewhat counterintuitive in terms of where you may wish to invest.

To counter this, product providers are becoming more inventive, addressing liquidity by working with the index providers to create bespoke indexes, constructed using different criteria.

State Street, for example, has worked work Barclays on two such products defined as ‘advanced beta’.

Lesné said: “There are a few smart beta products emerging but it remains relatively niche [in fixed income] compared with equities. Two of our products reweighted the issuers based on two points of financial data – the ability to repay the debt and what they are doing with the money.”

Seen as about 20 years behind the developments in equities, the inherent inefficiencies of the bond markets – not being centrally traded – have made it difficult to apply passive strategies.

Christopher Aldous, managing director at Charles Stanley Pan Asset, said a primary advantage of using them was to mitigate the pricing differentials seen in bond markets, referred to as the bid/offer spread.

“Your underlying bonds might have spreads of 10% or more whereas ETFs, being subject to the UK listing rules, might only have a maximum spread of 3%.”

With the hurdles to direct bond investing too high – not just for private investors but even smaller institutions – ETFs seem to provide the solution.

“If you only have £50,000 or £500,000 to invest, the spreads [on the individual bond] would be too wide. ETFs provide a quick and easy access point to a market that was otherwise too challenging. It’s a nice evolution,” Lesné added.

One unintended consequence of the Federal Reserve decision in September to delay increasing interest rates, was a flood of assets into ‘junk’ ETFs, casting them into the spotlight.

“It is Not Right to Keep Bonds Out of Bounds”

Jose Garcia-Zarate, senior fund analyst at Morningstar said with the particularly opaque sectors of the market coming “out of the shadows”, once solely the domain of the institutional investor, it could lead to inadvertent pricing manipulation if everyone appears to be buying certain securities for no apparent reason, other than their being constituents of an index.

“High yield ETFs are great at providing visibility and access, but there may be some concerns if everybody suddenly invests into an ETF. It may distort the pricing dynamics of the underlying bonds, but [on the flip side] is it correct to keep an asset class totally out of bounds to the common investor?”

ETFs are often used by investors either for accessing cheap, tactical, short-term exposure to volatile markets, taking advantage of intra-day pricing or as fundamental core long-term holdings in a well-diversified portfolio.

In the latter case, investors could arguably strip out all these complexities and invest in a straightforward passive fund instead.

Garcia-Zarate said he believes if you are not trading frequently and only interested in a straightforward UK gilt fund, a traditional tracker fund might serve equally well but for anything beyond a fairly vanilla government bond fund, ETFs are the place to be.

Sleep added: “I see no economic difference in passive funds and ETFs but you will have more choice in the ETF space. For example, I am not aware of any passive funds that invest in high yield but there are plenty of ETFs. It’s a more developed market.”

The information contained within is for educational and informational purposes ONLY. It is not intended nor should it be considered an invitation or inducement to buy or sell a security or securities noted within nor should it be viewed as a communication intended to persuade or incite you to buy or sell security or securities noted within. Any commentary provided is the opinion of the author and should not be considered a personalised recommendation. The information contained within should not be a person's sole basis for making an investment decision. Please contact your financial professional before making an investment decision.

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About Author

Sam Shaw  is a financial journalist and broadcaster writing for Morningstar.